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Bank Stress Tests: The Government Isn't Going Far Enough

There are a couple of things that strike me as odd and even disturbing about the new congressional oversight report on the recent bank stress tests.

First, the “adverse scenario” on these 19 banks isn’t adverse enough. Didn’t we already know that? There were plenty of folks raising the specter of double-digit unemployment long ago. Only now that unemployment has climbed to a rate of 9.4% is the government suddenly saying it has “serious concerns” that perhaps the tests weren’t rigorous enough.

There’s also the massive problem of commercial real estate assets and loans—none of which have been calculated into the mix. Banks hold some $1 trillion of these loans, the report notes. Research out of Deutsche Bank shows that the majority of losses on these loans (never mind the derivatives and securities created off of them) won’t show up for another few years. The default rate of U.S. commercial real estate bank loans has already reached its highest level in 15 years and is not expected to peak until 2011, according to another new report by Real Estate Econometrics.

Two very respectable professors helped Congress put together the recent report and gave their blessing on the “solidly designed working model” of the stress tests, backing them up with the usual econometric hieroglyphics and mathematical models. The report recommends that banks and their regulators continue the stress tests. That seems reasonable: No doubt that we want to know if our banks are healthy and able to withstand tough economic headwinds.

But we also want to know if they are getting into trouble enough to take down the whole system. The 168-page report by the Congressional Oversight Panel reminds us that our regulators are still not able to assess that properly. The ability to understand the interconnectivity among banks and the risk they present, especially in the derivatives market, is still a big fat unknown. And the regulators and mathematical geniuses have yet to figure out a way to monitor or measure that risk.